External costs or benefits exist only if property rights have not been clearly defined and/or when the negotiation or enforcement cost exceeds damage.

Houses around golf courses are usually more expensive than those near airports. On the surface, it appears that the golf courses have generated uncompensated benefits and the airport uncompensated costs to the nearby house owners. Economists call uncompensated benefits external benefits or positive externalities, and uncompensated costs external cost or negative externalities.

But the fact that the value of houses is enhanced by their proximity to golf courses and reduced by their proximity to airports only shows the physical presence of positive and negative spillovers. The presence of physical spillovers does not always mean that these spillovers have not been compensated. Specifically, the houses and golf courses are usually jointly developed by the same company (see also Your Customers Are My Customers). In other words, the attractiveness of being located next to the golf courses has already been factored into the price of the nearby houses. Similarly, house owners around airports might already have been compensated by the lower prices they pay for their houses.

When the positive or negative physical spillovers have been compensated through price adjustments, the benefits or costs of these physical spillovers are said to have been internalized. After the benefits or costs have been internalized, the physical spillovers might still be visible to outside observers. But these physical spillovers can no longer be considered as externalities because the price adjustments have compensated for any diminution of property rights (see also Busy Bees).

Thus, the ownership arrangement and the time sequence of events must be taken into account before any determination can be made as to the existence of uncompensated positive and negative spillovers. Even if a later event adversely impacts the value of an earlier event, the adverse effects could be compensated through negotiation or litigation as long as the property right of the earlier event has been violated.

The market has been quite creative in internalizing positive and negative spillovers. An overlooked example is the carefully selected mixture of shops in malls. There are the notable anchor stores to generate customer traffic for the other stores. And the ubiquitous food court serves to keep the customers inside the mall as much as possible. These symbiotic relationships among stores have been designed to internalize positive spillovers. The internalization process is reflected in the rent differentials among the stores. Specifically, the stores that generate the most traffic are charged lower rent per square foot. These are the anchor stores and clothing stores. Those stores that benefit greatly from the customer traffic end up paying the highest rent. These are the food court and jewelry stores.

In all these cases, the positive spillovers have all been internalized (i.e., compensated) because the property rights to these spillovers have been clearly assigned to the mall developers. Thus, positive or negative externality exists only if property rights have not been clearly defined and/or when the negotiation or enforcement cost exceeds damage (see also Scoop Your Poop). For example, the exhaust from the tailpipes of motor vehicles is clearly an example of negative externality because the property right over the public atmosphere has not been or cannot be easily defined.

In other words, when externality (a property right concept) is present, there must be spillovers (a physical concept). But when there are spillovers, externality may or may not be present. If the spillovers have been compensated (i.e., internalized), there would be no externality even though the spillovers may still be visible to outside observers. Internalization of uncompensated benefits or costs does not necessarily mean the suppression of all physical spillovers. It does mean that the remaining physical spillovers will be adjusted to the most efficient level where marginal social benefits are equal to the marginal social cost.